In December 2017, as part of the Tax Cuts and Jobs Act (“TCJA”), Congress established a new tax incentive program to promote investment in certain low-income communities designated by the IRS as qualified opportunity zones. The tax incentives obtained by investing in a qualified opportunity fund (“QOF”) allow taxpayers to (i) defer paying taxes on capital gain from the sale or exchange of appreciated assets; (ii) receive a permanent exclusion from taxation of up to 15 percent of the originally deferred gain; and (iii) for taxpayers that hold their investment in the QOF for at least 10 years, a permanent exclusion from taxation for any appreciation in excess of the deferred gain.

On April 17, the Treasury Department released its second round of guidance on Opportunity Zone investments in the form of proposed regulations (the “New Proposed Regulations”). These newly proposed regulations supplement and in some cases revise the proposed regulations issued in October of 2018 (the “October Proposed Regulations”). [1]

The New Proposed Regulations provide further clarity, but leave many questions unanswered. This is Part II of our series of blog posts on the New Proposed Regulations. This post addresses key issues relating to the requirements for qualified opportunity zone businesses and qualified opportunity zone business property. For Part I of our explanation, which addresses qualified investments in qualified opportunity funds, please click on the link here.

GUIDANCE ON THE REQUIREMENTS FOR QUALIFIED OPPORTUNITY ZONE BUSINESSES

In order to qualify as a qualified opportunity fund (a “QOF”), a fund must have at least 90 percent of its assets invested in qualified opportunity zone property. Qualified opportunity zone property includes stock in a corporation and an equity interest in a partnership if the corporation or partnership is, or has been organized for the purpose of being, a qualified opportunity zone business.

The TCJA set forth specific requirements to be a qualified opportunity zone business. The October proposed Regulations and the New Proposed Regulations clarify and expand on some of these requirements.

In general, for a trade or business to be a qualified opportunity zone business (i) 70 percent or more of the tangible property owned or leased by the business must be qualified opportunity zone business property, (ii) at least 50 percent of the gross income of the business must be derived from the active conduct of a trade or business in a qualified opportunity zone, (iii) a substantial portion of the intangible property of the business must be used in the active conduct of the trade or business in the qualified opportunity zone, (iv) less than five percent of the average of the aggregate unadjusted basis of the property of the business may be from financial assets, and (v) the business must not be one of the so-called “sin businesses.”

THE 70 PERCENT OF TANGIBLE PROPERTY TEST

To be a qualified opportunity zone business 70 percent or more of the tangible property owned or leased by the business must be qualified opportunity zone business property.

How is the 70 percent tangible property test measured?

Under the New Proposed Regulations the 70 percent test is determined by a fraction, the numerator of which is the total value of all tangible qualified opportunity zone business property owned or leased by the business and the denominator is the value of all tangible property owned or leased by the business.

How is the value of tangible property determined for the 70 percent test?

For purposes of the 70 percent test, a taxpayer that has certified audited financial statements (or financial statements that are required to be filed with the SEC or certain or other federal agencies) may (i) use the value of the property that is reported (or that would be reported) on their financial statement or (ii) use the unadjusted cost basis of tangible property owned by the business and use a present value method for tangible property leased by the business. Taxpayers without audited financial statements may use the method described in clause (ii).

In certain circumstances, a taxpayer may utilize the valuation methodology that is used for determining compliance with the 90 percent asset requirement.

Prior to the New Proposed Regulations, taxpayers with applicable audited financial statements were only permitted to use the value of the property reported on their financial statements.

THE 50 PERCENT OF GROSS INCOME TEST

To be a qualified opportunity zone business at least 50 percent of the gross income of the business must be derived from the active conduct of a trade or business in a qualified opportunity zone.

How can a business meet the 50 percent gross income test?

The New Proposed Regulations provide three safe harbors and a facts and circumstances test that can be used to meet the 50 percent gross income test.

The three safe harbors are:

Hours-of-work safe harbor. A business can rely on this safe harbor if at least 50 percent of the total hours of services performed by employees, independent contractors, and employees of independent contractors for the trade or business during the taxable year are performed in the opportunity zone.

Cost-of-services safe harbor. A business can rely on this safe harbor if the total amount paid for services performed by employees, independent contractors, and employees of independent contractors in the opportunity zone is 50 percent or more of the total cost of services.

Business-functions-and-tangible property safe harbor. A business can rely on this safe harbor if the management and operational functions performed in the opportunity zone and tangible property located in the opportunity zone are each necessary to generate at least 50 percent of the gross income of the trade or business.

In addition to these safe harbors, a business can look at its facts and circumstances to show that at least 50 percent of its gross income is derived from the active conduct of a trade or business in the qualified opportunity zone.

Does gross income from non-opportunity zone property count toward the 50 percent gross income test?

In some cases yes. Where an opportunity zone property and a non-opportunity zone property are contiguous and the opportunity zone property is substantial (based on square footage) in relation to the non-opportunity zone property, the non-opportunity zone property will be treated as if it is qualified opportunity zone property for purposes of the 50 percent gross income location test and the substantial use of intangible property test (described below). It is unclear what ratio of opportunity zone property to non-opportunity zone property will be considered “substantial.” The New Proposed Regulations do not adopt this rule for purposes of the 70 percent qualified opportunity zone business property test.

THE SUBSTANTIAL USE OF INTANGIBLE PROPERTY REQUIREMENT

To be a qualified opportunity zone business a substantial portion of the intangible property of the business must be used in the active conduct of the trade or business in the qualified opportunity zone.

What is “substantial” for purposes of the substantial use of intangible property in the active conduct of a trade or business in the qualified opportunity zone requirement?

The New Proposed Regulations clarify that the substantial use requirement for intangible property is met if at least 40 percent of the intangible property of the business is used in the active conduct of a trade or business in the qualified opportunity zone. As noted above, in some cases the use of intangible property in contiguous property that is not in an opportunity zone will count towards the 40 percent test.

What is the active conduct of a trade or business for purposes of the substantial use of intangible property requirement?

The New Proposed Regulations reserve on the definition of an active conduct of a trade or business but do state that the ownership and operation (including leasing) of real property is the active conduct of a trade or business provided that the activity is not merely entering into a triple net lease with respect to the property.

THE 5 PERCENT FINANCIAL ASSETS TEST

To be a qualified opportunity zone business less than 5 percent of the average aggregate unadjusted bases of the property of the business may be attributable to financial assets. For purposes of this test, a reasonable amount of working capital held in cash or cash equivalents with a term of less than 18 months is not treated as financial assets.

What is considered a reasonable amount of working capital for purposes of the 5 percent test?

The New Proposed Regulations expanded the working capital safe harbor established by the October Proposed Regulations working capital safe harbor. Pursuant to the safe harbor, an amount of working capital is reasonable if (i) the amounts are designated in a writing for the development of a trade or business in a qualified opportunity zone, (ii) there is a written schedule for the use of the funds within 31 months of the receipt of the working capital, and (iii) the working capital is actually used in a manner substantially consistent with the written description and schedule. Further, delays caused by slow government action (e.g. issuing of permits, zoning approvals, etc.) will not violate the requirements for the working capital safe harbor. Finally, the New Regulations make clear that a business can apply the safe harbor more than once such that subsequent funding may also rely on the safe harbor if the requirements described above are met.

GUIDANCE ON THE REQUIREMENTS FOR QUALIFIED OPPORTUNITY ZONE BUSINESS PROPERTY

Under the New Proposed Regulations, in order to qualify as qualified opportunity zone business property (“QOZBP”) (i) the property must be tangible property acquired by the business from an unrelated party or leased after December 31, 2017, (ii) original use or substantial improvement requirements must be met, and (iii) during at least 90 percent of the holding period for the tangible property, 70 percent or more of the use of the property must be in a qualified opportunity zone.

What are the requirements for leased property?

For leased property to count as good opportunity zone business property, the lease must have been entered into after December 31, 2017, the terms of the lease must be arms-length market terms and the rate must be a market rate. Unlike in the case of purchased property, the lessor may be a related party (additional requirements apply if the lease is from a related party). In the case of leased real property there must not have been a plan or expectation for the business to purchase the leased property for other than its fair market value.

What counts as original use of leased or acquired tangible property?

The original use of leased tangible property commences on the first day the leased property is placed in service in the qualified opportunity zone for purposes of depreciation. For leased or owned tangible property that has been unused or vacant for an uninterrupted period of at least 5 years, the original use begins on the date after that period of unuse or vacancy when the property is placed in service. In addition, used tangible property that is acquired satisfies the original use requirement if the property has not been previously used in the opportunity zone. Special rules allow leased tangible personal property that does not meet the original use test to count as original use if the lessee becomes the owner of tangible property that is qualified opportunity zone business property having a value not less than the value of that leased tangible personal property. and certain other requirements are met.

Do the New Proposed Regulations require a substantial improvement of land within the qualified opportunity zone?

It depends. The New Proposed Regulations make clear that land within a qualified opportunity zone need not be substantially improved. Such land can qualify as opportunity zone business property so long as it is used in the trade or business of the qualify opportunity fund or qualified opportunity zone business.

However, a qualified opportunity fund may not rely on this provision until the New Proposed Regulations become final in situations where the land is unimproved or minimally improved and the qualified opportunity fund or the qualified opportunity zone business purchases the land with an expectation, an intention or a view not to improve the land by more than an insubstantial amount with 30 months after the date of purchase.

How is inventory in transit treated for purposes of the 70 percent use in a qualified opportunity zone test?

The New Proposed Regulations make clear that inventory in transit from a vendor to a facility in the qualified opportunity zone, or from such a facility to a customer may be treated as property used in the qualified opportunity zone for purposes of the 70 percent test.

CONCLUSION

While it is important to remember that the New Proposed Regulations are not final, taxpayers may rely on the New Proposed Regulations prior to the date they become final (other than the section of the proposed regulations that addresses the rules for unimproved land so long as taxpayers apply the New and October Proposed Regulations consistently and in their entirety.)

[1] For a general discussion of the Opportunity Zone rules see our August 15, 2018 client update available here. For information on the first set of regulations issued with respect to these rules see our November 9, 2018 client update available here.

In December 2017, as part of the Tax Cuts and Jobs Act (“TCJA”), Congress established a new tax incentive program to promote investment in certain low-income communities designated by the IRS as qualified opportunity zones. Section 1400Z-2 of the Internal Revenue Code provides three compelling tax incentives to encourage investment in qualified opportunity funds (“QOFs”).

Taxpayers can defer paying taxes on capital gain from the sale or exchange of appreciated assets by investing such gain in a QOF within 180 days following such sale or exchange. Such gain may be deferred until the earlier of (i) when the investment is sold or exchanged or (ii) December 31, 2026.

Investors receive a step-up in the basis equal to 10% of the original deferred gain if the investment in the QOF is held for at least five years, with an additional 5% basis step-up if the investment is held for seven years. These basis step-ups can result in permanent exclusion from taxation of up to 15% of the originally deferred gain.

If the investor holds the investment in the QOF for at least 10 years, an elective basis adjustment made upon sale of the interest in the QOF provides a permanent exclusion from taxation for any appreciation in excess of the deferred gain.

On April 17, 2019, the Treasury Department released its second round of guidance on opportunity zone investment in the form of proposed regulations (the “New Proposed Regulations”). These newly proposed regulations supplement and in some cases revise the proposed regulations issued in October 2018 (The “October Proposed Regulations”).

In particular, the New Proposed Regulations provide:

Guidance related to investments in QOFs including rules for the transfer of property other than cash to a qualified opportunity fund, guidance on the purchase of eligible investments, rules for investment rollovers, guidance on what triggers a taxable inclusion, rules for mixed investments in funds, and guidance on investments by partnerships, S‑corporations and consolidated groups.

Guidance related to qualified opportunity zone businesses including workable rules for businesses that straddle opportunity zone and non-opportunity zones, guidance on the use of intangible property and favorable safe harbors for the 50 percent gross income location test.

Guidance on opportunity zone business property including rules that will permit investors to lease rather than purchase opportunity zone property, and a clarification that for purposes of the holding period requirement “substantially all” means 90 percent.

Guidance on QOFs including a reinvestment rule for funds, relief from the 90 percent asset test for new capital, and anti-abuse rules.

The New Proposed Regulations do provide further clarity, but still leave many questions unanswered. In light of the length and complexity of the New Proposed Regulations we will release a multi-part series of blog posts that will each address key issues relating to a specific component of the opportunity zone rules. Key issues relating to qualified investments in QOFs are highlighted in this Part I. We will unpack and explain additional aspects of the New Proposed Regulations in future blog posts.

What types of gain can be deferred through investment in a QOF?

The TCJA left open the question of what types of “gain” are eligible for deferral by simply stating “gain from the sale to, or exchange with, an unrelated person of any property held by the taxpayer.” The October Proposed Regulations clarified that only capital gain is eligible for deferral. The New Proposed Regulations make clear that in the case of Section 1231 gain, only capital gain net income for a taxable year is eligible for deferral.

Can gain from the sale or other transfer of property to a QOF in exchange for an equity interest in the QOF be deferred?

No. Under the New Proposed Regulations, gain from the sale or other transfer of property to a QOF in exchange for an equity interest in the QOF is not eligible for deferral.

Can gain from the sale or other transfer of property to a person other than a QOF in exchange for an equity interest in a QOF be deferred?

No. Capital gain recognized for federal income tax purposes in connection with transfer of property to a person other than a QOF in exchange for an equity interest in the QOF is not eligible for deferral under the New Proposed Regulations.

Can a taxpayer defer eligible gain by acquiring an equity interest in a QOF from a person other than a QOF?

Yes. The New Proposed Regulations provide that if a taxpayer acquires an equity interest in a QOF from a person other than the QOF, then the amount of gain eligible for the taxpayer’s deferred election is the amount of the cash, or the fair market value of the other property, that the taxpayer exchanged for the eligible interest in the QOF, as determined immediately before the exchange.

Do carried interests qualify for opportunity zone tax benefits?

No. Services rendered to a QOF are not considered a Section 1400Z-2(a)(1)(A) investment. Thus, if a taxpayer receives an equity interest in a QOF for services rendered to the QOF or to a person in which the QOF holds any direct or indirect equity interest, then the interest in the QOF that the taxpayer receives is treated as a separate investment which does not qualify for opportunity zone tax benefits.

Can a taxpayer make an equity investment in a QOF by contributing property in a nonrecognition transaction?

Yes. For property contributions, the deferral election is limited to the lesser of the taxpayer’s adjusted basis in the equity interest received in the transaction without regard to section 1400Z-2(b)(2)(B) (generally, the taxpayer’s basis in the property contributed), or the fair market value of the equity interest received in the transaction, both as determined immediately after the contribution. This rule applies separately to each item of property contributed to a QOF. If the fair market value of the equity interest in the QOF received is in excess of the taxpayer’s adjusted basis in the equity interest received, without regard to section 1400Z-2(b)(2)(B), then the taxpayer’s investment is a mixed funds investment to which Section 1400Z-2(e)(1) applies.

Conclusion

The New Proposed Regulations provide clarity on key issues but leave many questions unanswered. We will address additional issues under the New Proposed Regulations in future blog posts on the topics of operating businesses, investment rollovers, leases, reinvestment, taxable inclusion events and more.

While it is important to remember that the New Proposed Regulations are not final, taxpayers may rely on the New Proposed Regulations prior to the date they become final (other than the section of the proposed regulations that addresses the rules for the exemption of gain on sales after ten years) so long as taxpayers apply the New and October Proposed Regulations consistently and in their entirety.

]]>https://www.corporatesecuritieslawblog.com/2019/04/opportunity-zones-update-qof/feed/0New Effort to Exempt Crypto Currency from Certain SEC, Tax and Other Regulatory Burdenshttps://www.corporatesecuritieslawblog.com/2019/04/tax-digital-unit/
https://www.corporatesecuritieslawblog.com/2019/04/tax-digital-unit/#respondFri, 19 Apr 2019 21:09:19 +0000https://www.corporatesecuritieslawblog.com/?p=3003Continue Reading]]>A new bill, the Token Taxonomy Act was introduced to congress to amend the Securities Act of 1933 and the Securities Exchange Act of 1934 to exclude digital tokens from the definition of a security, to direct the Securities and Exchange Commission to enact certain regulatory changes regarding digital units secured through public key cryptography, to adjust taxation of virtual currencies held in individual retirement accounts, to create a tax exemption for exchanges of one virtual currency for another, to create a de minimis exemption from taxation for gains realized from the sale or exchange of virtual currency for other than cash, and for other purposes.

If passed this will be a huge boost for cryptocurrency.

The bill is pretty technical. Some of the highlights are as follows.

For purposes of the act, the term ‘digital token’ means a digital unit:

(A) that is created—

(i) in response to the verification or collection of proposed transactions;
(ii) pursuant to rules for the digital unit’s creation and supply that cannot be altered by any single person or persons under common control; or
(iii) as an initial allocation of digital units that will otherwise be created in accordance with clause (i) or (ii);

(B) that has a transaction history that—

(i) is recorded in a distributed, digital ledger or digital data structure in which consensus is achieved through a mathematically verifiable process; and
(ii) after consensus is reached, resists modification or tampering by any single person or group of persons under common control;

(C) that is capable of being transferred between persons without an intermediate custodian; and

(D) that is not a representation of a financial interest in a company or partnership, including an ownership interest or revenue share.

Among other things, the bill seeks to preempt state law as follows.

No law, rule, regulation, or order, or other administrative action of any State or any political subdivision thereof—

(A) requiring, or with respect to, registration or qualification of securities, or registration or qualification of securities transactions, shall directly or indirectly apply to a digital token;

(B) shall directly or indirectly prohibit, limit, or impose any conditions upon the use of—

(i) with respect to a digital token, any disclosure document concerning an offer or sale of a digital token that is prepared by or on behalf of a person developing, offering, or selling a digital token; or
(ii) any proxy statement, report to digital token-holders, or other disclosure document relating to a digital token or a person developing, offering, or selling a digital token;

(C) shall directly or indirectly prohibit, limit, or impose conditions, based on the merits of a digital token offering or a person developing, offering, or selling a digital token, upon the offer or sale of any digital token; or

(D) shall directly or indirectly require the filing of any notices or other documents, or the assessment of any fees, with respect to digital tokens or digital token transactions.

Additionally, states and political subdivisions thereof shall retain jurisdiction under the laws of such State to investigate and bring enforcement actions with respect to fraud or deceit, or unlawful conduct by any person, in connection with digital tokens or digital token transactions.

Another important provision of the bill treats certain exchanges as non-taxable. The bill proposes to amend the Internal Revenue Code to state that exchange of virtual currency (as defined) shall be treated as if such exchange were an exchange of real property; that Gross income shall not include gain (up to $600) from the sale or exchange of virtual currency for other than cash or cash equivalents.

It is too early to tell whether this bill has a chance of passing. If it does, it will be historic.

]]>https://www.corporatesecuritieslawblog.com/2019/04/tax-digital-unit/feed/0United States Supreme Court Holds That Knowing Dissemination of False Statements Made by Others Can Constitute Primary “Scheme Liability” In Violation of Rule 10b-5(a) and (c)https://www.corporatesecuritieslawblog.com/2019/04/false-statements-violation/
https://www.corporatesecuritieslawblog.com/2019/04/false-statements-violation/#respondMon, 01 Apr 2019 17:29:38 +0000https://www.corporatesecuritieslawblog.com/?p=2999Continue Reading]]>In Lorenzo v. Securities & Exchange Comm., No. 17-1077, 2019 WL 1369839 (U.S. Mar. 27, 2019), the Supreme Court of the United States (Breyer, J.) held that an individual who did not “make” a false or misleading statement within the meaning of Janus Capital Group, Inc. v. First Derivative Traders, 564 U.S. 135 (2011) (blog article here), but instead disseminated it to potential investors with intent to defraud, can be held to have employed a scheme to defraud and/or engaged in an act, practice or course of business to defraud in violation of subsections (a) and (c) of Securities and Exchange Commission (“SEC”) Rule 10b-5, 17 C.F.R. § 240.10b-5. This decision broadens the scope of primary liability under Rule 10b-5 beyond those who make false and misleading statements to include those who knowingly “disseminate” (i.e., communicate to potential investors) such false or misleading statements. Although this decision involved an SEC enforcement action, it is likely to be invoked by plaintiffs in private securities litigation to expand the scope of named defendants beyond the issuer and individuals directly responsible for making public statements on the issuer’s behalf.

The relevant facts were not in dispute. The defendant represented himself as “Vice President-Investment Banking” for a registered broker-dealer in Staten Island, New York. In 2009, he sent emails to prospective investors at the direction of his boss, who supplied the content and approved the messages. Those emails contained false and misleading information about the client’s business. Defendant allegedly knew that.

The SEC brought an enforcement action. It determined that defendant violated Rule 10b-5 (among other provisions of the federal securities laws), issued a $15,000 fine and bar order. Defendant appealed. He argued, inter alia, that he could not be held liable under Rule 10b-5(b), which prohibits (in pertinent part) “mak[ing] any untrue statement of a material fact,” because he was not the “maker” of the statements in the emails at issue within the meaning of Janus Capital. The United States Court of Appeals for the District of Columbia Circuit agreed. SeeSecurities & Exchange Comm. v. Lorenzo, 872 F.3d 578 (D.C. Cir. 2017). The Court of Appeals nevertheless held that defendant’s conduct violated Rule 10b-5(a) and (c) which prohibit (in pertinent part) “employ[ing] any device, scheme, or artifice to defraud” and “engag[ing] in any act, practice, or course of business which operates or would operate as a fraud or deceit.” The D.C. Circuit’s decision conflicted with decisions in other Circuits holding that alleged misconduct involving misstatements in violation of Rule 10b-5(b) cannot also give rise to “scheme liability” under Rule 10b-5(a) and (c). See, e.g., WPP Luxembourg Gamma Three Sarl v. Spot Runner, Inc., 655 F.3d 1039 (9th Cir. 2011).

The Supreme Court affirmed the decision of the D.C. Circuit. In its ruling, the six-justice majority (Kavanaugh, J., did not participate) relied heavily upon the plain language of the Rule and dictionary definitions of its terms. “It would seem obvious that the words in [Rule 10b-5(a) and (c)] are, as ordinarily used, sufficiently broad to include within their scope the dissemination of false or misleading information with the intent to defraud.” The Court also seemed influenced by its view of the egregiousness of the facts of the case:

[W]e see nothing borderline about this case, where the relevant conduct (as found by the [SEC]) consists of disseminating false or misleading information to prospective investors with the intent to defraud. And while one can readily imagine other actors tangentially involved in dissemination—say, a mailroom clerk—for whom liability would typically be inappropriate, the petitioner in this case sent false statements directly to investors, invited them to follow up with questions, and did so in his capacity as vice president of an investment banking company.

The dissent (Thomas, J., in which Gorsuch, J., joined) argued that the majority’s decision undermined the limitations on the scope of securities liability established in, among other cases, Janus Capital and Central Bank of Denver, N. A. v. First Interstate Bank of Denver, N. A., 511 U.S. 164 (1994) (no private right of action for aiding and abetting securities fraud). The majority commented that “we can assume that Janus would remain relevant (and pre­clude liability) where an individual neither makes nor disseminates false information—provided, of course, that the individual is not involved in some other form of fraud” (emphasis in original). With respect to the blurring of the distinction between primary and secondary (aiding and abetting) liability, the majority acknowledged an overlap between the two types of liability:

Those who disseminate false statements with intent to defraud are primarily liable under Rules 10b-5(a) and (c) . . . , even if they are secondarily liable under Rule 10b-5(b). [Defendant] suggests that classifying dissemination as a primary violation would inappropriately subject peripheral players in fraud (including him, naturally) to substantial liability. We suspect the investors who re­ceived [his] e-mails would not view the deception so favorably. And as Central Bank itself made clear, even a bit participant in the securities markets “may be liable as a primary violator under [Rule] 10b-5” so long as “all of the requirements for primary liability . . . are met.”

The dissent also noted that the Court’s interpretation that Rule 10b-5(a) and (c) encompasses conduct addressed more directly in Rule 10b-5(b) effectively rendered subsection (b) superfluous. Here, too, the majority seemed unconcerned, given the breadth of the plain language of the Rule and the salutary purposes of the federal securities laws.

The Court’s decision in Lorenzo expands the scope of primary liability under Rule 10b-5. Although the majority did limit the expansion in scope in this case to those who “disseminate” false statements, plaintiffs in private securities litigation likely will invoke Lorenzo as a basis to add as defendants individuals and entities alleged to have participated in the fraudulent scheme under Rule 10b-5(a) and (c) through activities besides “dissemination.” We note that although the Court did not explain the legal basis for which it would be “inappropriate” to hold a “mailroom clerk” or other “tangential” persons primarily liable for disseminating false or misleading statements made by others, that basis would appear to be the separate requirement set forth in Stoneridge Investment Partners, LLC v. Scientific-Atlanta, Inc., 552 U.S. 148 (2008) (blog article here), that investors plead and prove they (or the market generally) were aware of the deceptive conduct at issue, i.e., they knew of and relied upon the fraudulent acts of the “mailroom clerk” or other “tangential” participants. Lower courts will need to grapple with these issues left open by the Supreme Court’s decision in this case.

]]>https://www.corporatesecuritieslawblog.com/2019/04/false-statements-violation/feed/0Second Circuit Holds That Issuer’s Alleged Statements Concerning Its Regulatory Compliance Efforts Do Not Constitute Material Misstatementshttps://www.corporatesecuritieslawblog.com/2019/03/cigna-material-misstatements/
https://www.corporatesecuritieslawblog.com/2019/03/cigna-material-misstatements/#respondTue, 12 Mar 2019 22:22:41 +0000https://www.corporatesecuritieslawblog.com/?p=2992Continue Reading]]>In Singh v. Cigna Corp., No. 17-3484-cv, 2019 U.S. App. LEXIS 6637 (2d Cir. Mar. 5, 2019), the United States Court of Appeals for the Second Circuit affirmed the dismissal of a class action complaint that purported to base a securities fraud claim upon alleged statements made by defendant Cigna Corporation (“Cigna” or the “Company”) about its efforts to comply with Medicare regulations. According to the complaint, the statements materially misled investors and, when news of regulatory non-compliance surfaced, the Company’s stock price declined. The Second Circuit held the statements to be only “generic” descriptions of the Company’s compliance efforts. The Court held that no reasonable investor would rely upon them as “representations of [the Company’s] satisfactory compliance,” and so they did not constitute material misstatements sufficient to support a securities claim.

In early 2012, Cigna, a health services organization, acquired another company in the fast-growing U.S. Medicare insurance market through an acquisition. As a result, the Company became subject to significant regulatory requirements. In 2014 and 2015, the Company issued public statements generally addressing Medicare regulations. These disclosed that it had “established policies and procedures to comply with applicable requirements” and that it “expect[s] to continue to allocate significant resources” to compliance. In 2014, the Company also published a “Code of Ethics and Principles of Conduct,” in which its senior executives affirmed the importance of integrity and legal and regulatory compliance.

Beginning in 2014, the Centers for Medicare and Medicaid Services (“CMS”), the federal agency which administers Medicare, began sending the Company notices of regulatory violations. CMS thereafter audited the Company’s Medicare operations. In a January 21, 2016 letter, CMS informed the Company that it had substantially failed to comply with Medicare requirements and that CMS would impose “intermediate sanctions suspending enrollment of Medicare beneficiaries effective at 11:59 p.m. that night.” When the Company disclosed this letter the next day, its stock price declined. In July 2016, after it announced that it had already spent more than $30 million to remedy the cited violations and that it might not be able to timely and satisfactorily address matters arising from the sanctions, the Company’s stock price declined further.

In response to the January 2016 price decline, an investor filed a putative class action against the Company and certain of its officers under Section 10(b) of the Securities Exchange Act of 1934, 15 U.S.C. § 78j(b), and Securities & Exchange CommissionRule 10b-5, 17 C.F.R. § 240.10b-5, promulgated thereunder. After the July 2016 stock price decline, the appointed lead plaintiff filed an amended complaint to extend the class period. The defendants then moved to dismiss, and the United States District Court for the District of Connecticut granted the motion. It determined that plaintiffs failed to plead materially false or misleading statements and facts giving rise to a strong inference of scienter.

On appeal, the Second Circuit agreed that no material misrepresentation was pled (and so it did not reach the scienter issue). The Court’s opinion quickly disposed of the Code of Ethics allegations, calling the Company’s statements about the need to comply with ethical norms “a textbook example of ‘puffery’” upon which no reasonable investor would rely.

The alleged statements about Medicare compliance efforts fared no better. Although the Second Circuit acknowledged that descriptions about compliance efforts can “amount[] to actionable assurances of actual compliance,” the Court explained that this can happen only when the issuer “describe[s] its compliance mechanisms in confident detail” (emphasis added). That was not the case here. As the Second Circuit observed, the challenged statements were “simple and generic assertions” about “having ‘policies and procedures’” and “allocating significant resources.” These “banal and vague” statements were also “tentative,” as the Company included language cautioning that Medicare requirements were complex and shifting, and that new national health care reform measures added to the overall uncertainty. According to the Court, the challenged statements “suggest[ed] a company actively working to improve its compliance efforts, rather than one expressing confidence in their complete (or even substantial) effectiveness.” The Court concluded that no reasonable investor would view them differently.

Following reports of an issuer’s non-compliance with regulatory requirements, it is not uncommon for securities plaintiffs to attempt to build a securities fraud case based upon the issuer’s earlier statements affirming the importance of regulatory compliance and generally describing its compliance efforts. Singh instructs that such statements do not present a basis for a securities fraud claim, and are properly rejected as merely “creative attempt[s] to recast corporate mismanagement as securities fraud.”

]]>https://www.corporatesecuritieslawblog.com/2019/03/cigna-material-misstatements/feed/0With the SEC, Cooperation is Keyhttps://www.corporatesecuritieslawblog.com/2019/03/cooperation-gladius/
https://www.corporatesecuritieslawblog.com/2019/03/cooperation-gladius/#respondFri, 08 Mar 2019 18:29:14 +0000https://www.corporatesecuritieslawblog.com/?p=2988Continue Reading]]>As an expensive “slap on the wrist,” the Securities and Exchange Commission (“SEC” or the “Commission”) recently concluded that approximately $12.7 million worth of funds raised in a 2017 Initial Coin Offering (“ICO”) by Gladius Network LLC (“Gladius”) were part of an unregistered securities offering, and all proceeds must be returned to investors. However, the penalty to Gladius for their regulatory violations was zero.

In recent years, the SEC has brought a number of actions involving offerings of digital asset securities including ICOs. These actions have principally focused on two important questions. First, the SEC examines when is a digital asset a “security” for purposes of the federal securities laws, and if the digital asset is a “security,” the SEC examines what registration requirements apply, if any. After the Commission warned in its Decentralized Autonomous Organization (DAO) Report of Investigation that ICOs can be securities offerings, Gladius raised approximately $12.7 million in digital assets. Gladius did not register its ICO under the federal securities laws. Moreover, the ICO did not qualify for an exemption from registration requirements. However, in the summer of 2018, Gladius proactively elected to self-report to the SEC’s enforcement staff and expressed an interest in taking prompt remedial steps, then cooperated with the SEC investigation. Unlike a number of other unregistered ICO enforcement actions, the SEC imposed no penalties because Gladius self-reported its conduct, agreed to compensate investors and agreed to register the tokens as a class of securities.

In other cases where proactive measures or cooperation with regulators were absent, the SEC enforced much harsher penalties. For example, two former executives behind the AriseCoin ICO were stopped by the SEC in 2018 and ordered in federal court to pay fines of nearly $2.7 million. Moreover, the then-CEO and then-COO responsible for the AriseCoin ICO were both prohibited from serving as officers or directors of public companies or participating in any future offerings of digital securities. The harsh penalties came after an SEC investigation, wherein there was little cooperation by AriseCoin. In fact, the SEC sought emergency relief to prevent investors from being victimized by the many misrepresentations throughout the AriseCoin ICO, and halted hundreds of millions in investment.

The SEC will impose penalties, even in ICOs where fraudulent misrepresentation is absent. Last year, the SEC imposed large civil penalties solely for ICO securities offering registration violations against two companies, CarrierEQ Inc. (Airfox) and Paragon Coin Inc. Both conducted ICOs, like Gladius, after the SEC warned that ICOs can be securities offerings. Airfox, a Boston-based startup, raised approximately $15 million worth of digital assets. Paragon, an online entity, raised approximately $12 million worth of digital assets. Neither Airfox nor Paragon registered their ICOs pursuant to the federal securities laws, nor did they qualify for an exemption to the registration requirements. The SEC imposed $250,000 penalties against each company and required actions to compensate and reimburse harmed investors who purchased tokens in the illegal offerings.

Since 2017, the number of new ICOs has steadily increased through 2018. However, as one might expect with the increasing competition, the amount of capital raised by each ICO has, on average, decreased. In 2018, the average amount of funds collected by a single ICO was $11.52 million. This is a sharp decrease from the average amount of funds collected by a single ICO in 2017, which was $24.35 million. Even after a dramatical downsizing, the crypto market is still larger than at the beginning of the upward trend in 2017, and many are focusing on alternative ways to finance the crypto industry in light of the fact that the SEC has not published new rules regarding digital securities or security tokens to address gray areas in this time of uncertainty.

The trend in leading crypto market exchanges is backing Security Token Offerings (STOs). Unlike an ICO, a security token denotes an investment contract into an underlying investment asset, such as stocks, bonds, funds or real estate investment trusts. When one invests in traditional stocks, ownership information is written on a document and a digital certificate is issued. For STOs, the process remains the same, except the transaction is recorded on a blockchain and a security token is issued. STOs offer the advantage of regulatory predictability to both traditional and crypto investors because security tokens are straightforwardly classified and fit into exhibiting regulatory frameworks in place for traditional securities. With STOs, all parties have an increased likelihood of avoiding regulatory purgatory, making STOs more attractive to most investors and issuers.

The era of mega ICOs is coming to a slow halt. Companies which have successfully conducted an ICO in the past would be wise to proactively correct any regulatory missteps, including the failure to register, make proper disclosures or any other litany of violations. Careful corrections to past ICOs may be necessary to avoid potentially enormous regulatory fines, as exemplified by the relative leniency the SEC showed with respect to Gladius based on its self-reporting and cooperative actions with the SEC enforcement staff.

]]>https://www.corporatesecuritieslawblog.com/2019/03/cooperation-gladius/feed/0Ninth Circuit Holds That Statutes Do Not Constitute “Rules or Regulations of the SEC” for Purposes of Sarbanes-Oxley Act Whistleblower Claimshttps://www.corporatesecuritieslawblog.com/2019/03/sarbanes-oxley-act-sox/
https://www.corporatesecuritieslawblog.com/2019/03/sarbanes-oxley-act-sox/#respondTue, 05 Mar 2019 00:39:12 +0000https://www.corporatesecuritieslawblog.com/?p=2984Continue Reading]]>In Wadler v. Bio-Rad Laboratories, Inc., No. 17-16193, 2019 WL 924827 (9th Cir. Feb. 26, 2019), the United States Court of Appeals for the Ninth Circuit held that statutes, including the Foreign Corrupt Practices Act (“FCPA”), do not constitute “rule[s] or regulation[s] of the Securities and Exchange Commission” (“SEC”) for purposes of determining whether an employee engaged in protected activity in a whistleblower claim under Section 806 of the Sarbanes-Oxley Act of 2002 (“SOX”). This decision clarifies the proper application of the express statutory language of Section 806.

Plaintiff was the general counsel for Bio-Rad Laboratories, Inc. (“Bio-Rad”). Beginning in 2009, plaintiff discovered that Bio-Rad salesmen had engaged in potential violations of the FCPA’s anti-bribery and record-keeping provisions. At his recommendation, Bio-Rad hired an outside attorney to investigate. The investigation identified several red flags, but no direct evidence of FCPA violations. Later, in 2012, an audit revealed that Bio-Rad owed a significant amount of money to its licensor due to missing documentation. Upon locating the documents, plaintiff thought they showed potential bribery. He advised Bio-Rad’s CEO, who indicated that he was not going to do anything about it. Plaintiff also discovered that Bio-Rad employees had entered into unauthorized contracts that did not include FCPA compliance provisions. In 2013, plaintiff delivered a memorandum to Bio-Rad’s board of directors, reporting what he thought were violations of the FCPA. Approximately four months later, Bio-Rad terminated his employment. He filed a lawsuit against Bio-Rad and the CEO for, among other things, alleged employment retaliation in violation of SOX for reporting alleged violations of the FCPA.

Section 806 of SOX protects employees who engage in lawful acts to expose various types of fraud. It prohibits publicly traded companies from discharging, demoting, suspending, threatening, harassing or otherwise discriminating against an employee who lawfully reports conduct that he or she reasonably believes constitutes (1) mail fraud in violation of 18 U.S.C. § 1341, (2) wire fraud in violation of 18 U.S.C. § 1343, (3) bank fraud in violation of 18 U.S.C. § 1344, (4) securities fraud in violation of 18 U.S.C. § 1348, (5) a violation of any provision of Federal law relating to fraud against shareholders or (6) a violation of “any rule or regulation of the [SEC].”

The United States District Court for the Northern District of California (Spero, M.J.) gave various jury instructions concerning when an employee engages in protected activity for purposes of SOX, and this depended on whether plaintiff disclosed information that he reasonably believed violated a “rule or regulation of the [SEC].” Even though the FCPA provisions at issue concerning bribery, a failure to keep detailed records, knowingly falsifying records and knowingly circumventing internal accounting controls are contained in the statutory language of Section 13 of the Securities Exchange Act of 1934, and not in a rule or regulation of the SEC, the district court instructed the jury that rules or regulations of the SEC include the statutory provisions of the FCPA.

The jury returned an $11 million verdict in favor of plaintiff on this claim. Defendants appealed. Defendants argued that plaintiff’s disclosure of the alleged FCPA violations was not protected activity under SOX because the statutory provisions of the FCPA are not “rule[s] or regulation[s] of the SEC.” The Ninth Circuit agreed, observing that “an FCPA provision is not a rule or regulation of the SEC,” and holding that the natural and plain reading of “rule or regulation” in Section 806 suggests that it encompasses only administrative rules or regulations, not statutes. The Court held further that it was certainly not harmless error for the district court to instruct the jury that FCPA violations fell into the category of rules or regulations of the SEC. The Ninth Circuit reversed and remanded to the district court to determine whether a new trial is warranted under a different theory of protected activity consistent with the statutory language of Section 806.

Wadler provides additional clarity regarding the proper interpretation of Section 806. Whether it results in any material reduction of whistleblower claims, though, is unclear. At the very least, the decision should lead to SOX whistleblower allegations tethered more closely to concrete alleged violations of specific rules or regulations of the SEC and/or the other five categories of misconduct described in Section 806, where feasible to do so.

Item 401(e) of Regulation S-K requires “a brief discussion of the specific experience, qualifications, attributes or skills that led to the conclusion that the person should serve as a director.” Item 407(c)(2)(vi) of Regulation S-K requires disclosure of how a company’s board (or nominating committee) implements policies that it follows with regard to the consideration of diversity in identifying director nominees.

In new CDIs Questions 116.11 and 133.13, the SEC stated that, to the extent the board or nominating committee, in determining the specific experience, qualifications, attributes, or skills of an individual for board membership, considered any such self-identified diversity characteristics of a director who consented to the disclosure of those characteristics, they would expect the company to identify those characteristics and discuss how they were considered. The SEC also stated that they expect that any description of diversity policies followed by the company would include a discussion of how the company considers the self-identified diversity attributes of a nominee, as well as any other qualifications its diversity policy takes into account, such as diverse work experiences, military service, or socio-economic or demographic characteristics.

While the SEC does not define diversity, permitting companies to define it in ways they consider appropriate, all public companies should be prepared to be more transparent in their diversity discussions in their SEC filings.

]]>https://www.corporatesecuritieslawblog.com/2019/02/sec-issues-new-guidance-on-diversity-disclosure-requirements/feed/0Court Finds Cybersecurity-Related Claims Sufficient in Securities Class Actionhttps://www.corporatesecuritieslawblog.com/2019/02/cybersecurity-claims-sufficient-securities-fraud-class-action/
https://www.corporatesecuritieslawblog.com/2019/02/cybersecurity-claims-sufficient-securities-fraud-class-action/#respondWed, 06 Feb 2019 20:38:32 +0000https://www.corporatesecuritieslawblog.com/?p=2977Continue Reading]]>In the aftermath of Equifax’s data breach, a federal court recently found that allegations of poor cybersecurity coupled with misleading statements supported a proper cause of action. In its decision, the U.S. District Court for the Northern District of Georgia allowed a securities fraud class action case to continue against Equifax. The lawsuit claims the company issued false or misleading statements regarding the strength and quality of its cybersecurity measures. In their amended complaint, the plaintiffs cite Equifax’s claims of “strong data security and confidentiality standards” and “a highly sophisticated data information network that includes advanced security, protections and redundancies,” when, according to the plaintiffs’ allegations, Equifax’s cybersecurity practices “were grossly deficient and outdated” and “failed to implement even the most basic security measures.” The court found that data security is a core aspect of Equifax’s business and that investors are likely to review representations on data security when making their investment decisions.

Key factors the court considered in allowing the case to continue were:

Statements on the company’s website and in SEC filings that it maintained “strong data security” and strong controls;

The company’s inadequate software patch management process;

Failure to encrypt sensitive data;

Inadequate authentication measures, such as weak passwords and lack of multi-factor authentication;

Failure to implement measures to monitor its networks;

Failure to segment its networks;

Inadequate staff training;

Failure to develop a data breach management plan; and

Inadequate follow-up on outside security audits.

Putting it Into Practice: Investors are paying attention to what companies are doing and saying with regard to cybersecurity. Particularly when touting strong cybersecurity practices, companies should carefully craft messaging that accurately reflects their cybersecurity posture, and they should make sure that their actions match their words by maintaining vigilance on cybersecurity.

]]>https://www.corporatesecuritieslawblog.com/2019/02/cybersecurity-claims-sufficient-securities-fraud-class-action/feed/0SEC Administrative Proceedings Against Public Companies for Failure to Remediate Material Weaknesses in Internal Control Over Financial Reportinghttps://www.corporatesecuritieslawblog.com/2019/02/material-weaknesses-icfr/
https://www.corporatesecuritieslawblog.com/2019/02/material-weaknesses-icfr/#respondTue, 05 Feb 2019 18:46:39 +0000https://www.corporatesecuritieslawblog.com/?p=2973Continue Reading]]>Public reporting companies that have material weaknesses in their internal control over financial reporting (“ICFR”) are required under Rule 308 of the Securities Exchange Act of 1934, as amended, to report such material weaknesses in their quarterly and annual reports along with proposed remedial measures. A material weakness is defined as a deficiency, or a combination of deficiencies, such that there is a reasonable possibility that a material misstatement of an issuer’s financial statements will not be prevented or detected on a timely basis.

On January 29, 2019, the Securities and Exchange Commission (“SEC”) settled charges with the following four public companies for alleged deficiencies in maintaining ICFR: Grupo Simec S.A.B. de C.V., CytoDyn, Inc., Lifeway Foods, Inc. and Digital Turbine, Inc. The SEC noted that these entities failed to maintain ICFR for seven to ten consecutive annual reporting periods and as a result are compelled to pay fines ranging from $35,000 to $200,000. The SEC indicated “… the four companies disclosed material weaknesses in ICFR involving certain high-risk areas of their financial statement presentation…and took months, or years, to remediate their material weaknesses after being contacted by the SEC staff.” Melissa Hodgman, an Associate Director in the Commission’s Enforcement Division said that the Commission is committed to holding public reporting companies accountable for failure to timely remediate material weaknesses in ICFR. Ms. Hodgman further stated, “Companies cannot hide behind disclosures as a way to meet their ICFR obligations. Disclosure of material weaknesses is not enough without meaningful remediation.”

ICFR is designed by, or under the supervision of, an issuer’s principal executive and principal financial officer, or persons performing similar functions, to provide reasonable assurance that the issuer’s financial statements are reliable and prepared in accordance with GAAP. (see Auditing Standard No. 5). ICFR describes the procedures used by public reporting companies to enhance the reliability of their financial statements by reducing the risk of material errors or misstatements.

Some recurring material weaknesses which have been identified by issuers over time and across industry sectors include: inadequate segregation of duties, inadequate procedures for reviewing and recording of transactions as well as the reporting of such transactions, and lack of sufficient accounting and financial reporting personnel able to implement formal accounting policies with an appropriate level of accounting knowledge. Issuers have remediated such material weaknesses by, among other things, engaging third-party service providers to assist with financial reporting, hiring staff with appropriate accounting and financial reporting knowledge and conducting training related to key accounting policies, internal controls and SEC compliance.

Any public issuers that have reported material weaknesses in their ICFR for more than one or two consecutive reporting periods either without offering a plan to address those weaknesses or offering a plan but failing to take corrective actions are at risk, and should discuss their remediation plans with experienced securities counsel to avoid potential exposure to liability.